Primer for Stock & Options

By Peter Kelman, Esq.

This column appeared in substantially the same form in the Boston Software News, September, 2000.

What is a stock option?

Many technology companies offer employees options in the company’s stock. An option is different from the stock itself. An option represents your right, not obligation (that’s why it’s an “option”), to acquire the stock of the company at a pre-determined price. A stock option is a contract between you and the company that allows you to buy a certain number of shares of the company’s stock at a fixed price, as determined by the board of directors.

After the market downturn are options still a good deal? Should I accept these options?

The recent downturn of the market points out a valuable, and previously often-overlooked, aspect of stock options, namely that the value of an option is speculative; it is not money in the bank. The value of an option can only be calculated in the future, when you acquire company stock at the option price (“exercise your option”) and then, most importantly, sell the stock. If the value of your company’s stock has risen since you acquired your option, and your selling price is higher than your option price, you will make money. If the market price has dropped, the value of your options has also decreased. The bottom line is that while stock options have no downside, they are vastly different from the feel of money you receive as salary. Beware of accepting a high percentage of options in lieu of salary.

Am I taxed for this?

You pay no tax when you receive a stock option. Assuming that these options are “Qualified” (sometimes called Incentive Stock Options or “ISOs”), you also do not pay a tax when you exercise your option (i.e. when you buy your company’s stock). If you then sell your stock either to the company or to another person, and receive more money for the stock than you paid for the option, your gain will be taxed. Under our current tax laws, if you hold the stock for one year or more after exercising your option, your gain will be capital gain, which is generally taxed at a lower rate than other income, or ordinary income. However, typically holders of options exercise their options and then sell the resulting stock in a simultaneous transaction. If you do this, you spend no money, you merely receive the excess value of your stock over the cost of the option. This excess value is treated as ordinary income and is taxed at conventional rates.

If you are concerned about the tax consequences of this transaction, please do not rely on this brief explanation. Seek the advice of an accountant, lawyer, or some other financial professional.

Will I have a voice in running the company?

By state law, as an option holder, you have no special rights in the governance of the company. You are not a shareholder. A shareholder votes to elect the company’s board of directors and gets to vote on certain other transactions. An optionholder does not have these rights.

My company has announced that it is going public. I have been instructed not to mention this to anyone, that we are in the “quiet period.” What does this mean?

Going public is a complicated process that consists of many steps that must take place before a company can sell its stock on a public exchange. Part of the quid pro quo of going public is that for the public to make an informed investing decision about whether to buy a company’s stock, that company must fully make available certain information about itself. The Securities and Exchange Commission (SEC) watches these things very carefully and will penalize a company if it finds that the company attempted to sell stock without making full disclosure. Companies advise employees and other “insiders” not to discuss the fact that the company is going public, in case such a discussion is construed as an attempt to sell the company’s stock without going through the required process of formal disclosure. While it may seem remote to you, “gun jumping” or illegally stimulating interest in a stock, can sink a company’s efforts to go public.

My company will soon have an IPO. Will I get rich? Can I book my next vacation to the Cayman Islands instead of George’s Island?

An IPO (or Initial Public Offering) is an event principally intended to raise money for a company. It is a process whereby a company discloses information about itself to the public in the hope that the public will invest in the company. Thus it “goes public” in an effort to raise funds. By the law of large numbers, the company hopes that a large number of small investors will provide it with more money than a small number of large investors (banks and other financial institutions). Notice that the equation omits you, the employee. In other words, despite all the talk around the water cooler, a company does not undergo an IPO for the direct benefit of its employees. However, if the company’s stock does well, you may indeed profit by its good fortune. Thus the answer to your question is “It all depends.”

Will I find out if I am rich the day we go public?

No. If you own either stock or options in your company, the chances are that you have signed a document in which you agreed to certain restrictions if your company went public. Some of these restrictions are called “lock up” provisions. These restrictions affect your ability to sell stock in your company. Investors do not want to invest in a company, only to have the people who built the company quickly cash out and depart the company. Most underwriters (the bankers who take a company public) require that employees agree to hold their stock in the company anywhere from six months to two years before they can sell their shares. This assures investors that key employees will not leave when the company goes public. Until your restrictions lapse, and you can compare the price of your company’s stock with your cost of the stock, you won’t know whether you have made money on your stock.

With all these restrictions and uncertainties how am I better off if my company goes public? How do I benefit?

The chances are that you are better off as a shareholder of a publicly traded company as opposed to being a shareholder of a privately held company. The major benefit you receive when your company goes public is that there will be a ready market in which you can sell your stock when you want to. Furthermore, if and when you sell your stock, you will have a good idea how much your stock is worth. If you want to know the value of a share of publicly traded stock, just check the newspaper. But if you want to discover the value of share of stock in a closely held company, there may be no place to turn. Typically stock in a closely held company is valued by the company’s board of directors and they have a good deal of discretion in setting the valuation. Even if you know the value of stock in a closely held company, another hurdle to overcome before you can sell (or “liquidate”) your stock, is that you must find a buyer. Publicly traded stock generally has a ready buyer, the anonymous public. Closely held stock, generally has only one buyer, the company itself. If the company doesn’t buy your stock, then chances are no one will. Thus, while publicly traded stock does not guarantee that you will be rich, it does mean that, should you decide to sell your stock, you will be able to sell it and you will get a fair price for it. Whether you actually make a profit on the transaction depends, of course, on the per share price being more than what you paid for each share when you exercised your options.

The questions and answers presented in this column vastly oversimplify what can be highly complex issues of law. The point of this column is not to provide definitive legal advice on specific topics, but rather to sensitize readers to general legal issues described from the 10,000 foot perspective. In no way is this column intended to substitute for advice one would receive from an experienced practitioner on a particular issue.